Strengthening financial sector amid serious challenges

By Maha Prasad Adhikari                                                   

The global economic recovery remains slow and uneven, influenced by the lingering effects of the COVID-19 pandemic and ongoing geopolitical tensions. Many central banks continue to uphold tight monetary policies to manage inflation. In this interconnected global economy, policy harmonization is essential to mitigate the impact of external shocks on economic activity.

A resilient domestic financial system, supported by robust institutional and policy frameworks, is critical for withstanding external shocks, whether they arise from global financial crises, trade disruptions, or geopolitical tensions.

 

Significant Reforms in Nepal’s Financial Sector

 

Nepal's financial sector has undergone significant reforms through three key phases. The first phase, initiated in the mid-1980s, focused on promoting institutional development, liberalizing the banking sector, and expanding the range of financial services. The second phase, starting in the early 2000s, targeted improvements in regulatory frameworks, financial stability, and operational efficiency, particularly within public sector banks.

Since 2010, the focus has shifted towards financial consolidation, with efforts to merge and strengthen financial institutions

Since 2010, the focus has shifted towards financial consolidation, with efforts to merge and strengthen financial institutions. These reforms have aimed to enhance the sector’s resilience and its ability to withstand economic shocks, thus contributing to sustainable economic growth.

In parallel, the Nepal Rastra Bank (NRB) has undertaken significant operational reforms in monetary policy. Gradual reforms began with the introduction of the interest rate corridor in 2016/17, followed by a shift from reserve targeting to interest rate targeting in 2020/21. These changes were designed to improve the transmission of monetary policy. In 2023/24, the NRB introduced new instruments, including the Standing Deposit Facility (SDF), to further strengthen the implementation of the interest rate corridor and enhance liquidity management.

Recent policy reforms have focused on modernizing monetary policy operations, improving credit quality, emphasizing digital banking and FinTech, developing a modern payment system, and integrating it into the global financial market. Additionally, financial consolidation and enhanced coordination between monetary and macroprudential policies have remained key priorities.

The NRB has made concerted efforts to direct credit toward productive sectors, ensuring that the banking sector supports sustainable economic development while mitigating the risks of asset bubbles

The NRB has also made concerted efforts to direct credit toward productive sectors, ensuring that the banking sector supports sustainable economic development while mitigating the risks of asset bubbles. Financial inclusion remains a top priority, with measures to support MSMEs, increase access to financial services, and promote financial literacy and consumer protection.

Despite several global and domestic shocks—including the 2008 global financial crisis, the 2015 earthquake, and the COVID-19 pandemic—Nepal's financial system has demonstrated resilience.

 

Economic Performance and Inflation

 

Nepal’s post-2015 earthquake growth momentum, which exceeded 7 percent, was disrupted by the COVID-19 pandemic and subsequent global supply chain shocks. Growth contracted from an average of 4.5 percent to 1.9 percent in 2022/23 but  rebounded to 3.9 percent in 2023/24. Sectors such as construction, manufacturing, and trade experienced contractions during this period.

The inflation reached as high as 8.6 percent in September 2022. But, due to timely policy interventions, subdued internal demand, and improvements in supply chains, it declined to 3.6 percent by July 2024. The average inflation rate for 2023/24 stood at 5.4 percent, well below the target of 6.5 percent.

Inflation reached as high as 8.6 percent in September 2022. But, due to timely policy interventions, subdued internal demand, and improvements in supply chains, it declined to 3.6 percent by July 2024

 

Foreign Exchange Reserves and Policy Measures

 

In the late 2021, Nepal experienced a significant decline in foreign exchange reserves. In response, the NRB implemented tighter monetary policies to protect reserves from further depletion. The central bank maintained a high-interest rate regime until May 2023, which played a crucial role in improving the external sector and controlling inflation. To address the adverse effects of high interest rates, particularly on small and medium-sized enterprises, regulatory relaxations, loan rescheduling, and reclassification measures were introduced.

By July 2024, the external sector was in a relatively stable position, with a balance of payments and current account surplus, as well as foreign exchange reserves sufficient to cover 13.7 months of imports

Further reforms included the introduction of a working capital guideline to standardize credit assessment for corporate sectors. By July 2024, the external sector was in a relatively stable position, with a balance of payments and current account surplus, as well as foreign exchange reserves sufficient to cover 13.7 months of imports. The weighted average lending rate of commercial banks also declined to single digits, reflecting improved monetary conditions.

 

Challenges and the Path Forward

 

Despite recent progress, sluggish credit demand persists, even in the context of lower interest rates and ample liquidity. The slowdown in credit expansion underscores the need for targeted efforts to stimulate domestic demand and revitalize economic activity, particularly in the real sector.

Nepal’s economic landscape is marked by low growth, low savings, and low investment

Nepal’s economic landscape is marked by low growth, low savings, and low investment. In this context, there is often an expectation that monetary policy should extend beyond its traditional mandate, despite clear limitations. The financial system also faces structural challenges, including an underdeveloped insurance sector and capital market, particularly the bond market.

The financial system also faces structural challenges, including an underdeveloped insurance sector and capital market, particularly the bond market

As technological advancements and FinTech continue to reshape the financial system, enhancing cybersecurity and protecting against scams and data breaches are becoming increasingly important. While significant progress has been made in digital payments and settlements, further efforts are needed to ensure consumer protection and safety.

The NRB is also working on improving interoperability in domestic and cross-border payments. Additionally, the potential of central bank digital currencies is being explored to further enhance financial inclusion and the effectiveness of monetary policy transmission in the digital era.

The NRB is working on improving interoperability in domestic and cross-border payments

Conclusion

 

The path ahead requires addressing existing challenges while seizing opportunities to strengthen Nepal’s monetary and financial sectors. By maintaining a balanced approach to monetary policy, continuing reforms, enhancing regulatory frameworks, and fostering financial inclusion, the NRB looks to continue to navigate the complexities of the financial landscape while ensuring sustainable and inclusive growth.

(The writer is the current Governor of  the Nepal Rastra Bank)